First, a little about risk …

Every trader is intimately acquainted with risk. Trading both stocks and options has large
potential for rewards, but also risks.
In order to sustain a successful trading career, a trader must be
willing to accept risk. The basic rule of thumb I was taught many years ago
when I first started trading was “never trade with money you can't afford
to lose.” There are no guarantees
in trading that any position will yield a perfect reward. As a trader, you
settle for the probabilities and potentials, and manage risk accordingly. Having said that, however, by predefining the
risk you can afford to sustain, you can avoid making mistakes that jeopardize
your entire trading account, and career.

Most traders are always trying to locate new strategies that
offer healthy rewards with minimal risk.
It is only with trading experience that you are able to easily assess
the risk of a particular strategy and use it to your advantage. But, the basic rule of thumb remains the key
to successful trading: Never take on the
risk unless it's worth the return.

What are the two types of risks?

Basically, there are two types of risks – the known and the
unkown. Each time you place a trade, you are putting the risk of that trade on
the line. This is a known risk, because
it involves a specific amount of money.
The unknown risk that is lurking in the market can take on many
forms. Everything from economic or
political news, earnings, and natural disasters can have some effect on the
market, creating this unknown risk.

Risk is not viewed the same by every
trader…

One trader's perspective of risk may be viewed as irrational
thinking by another. Risk is relative,
but to the person who perceives it in a given moment, it is absolute and beyond
question in his/her mind.

Understanding and accepting risk is
the most important aspect of trading

There isn't any element of trading that is more important
than having a true understanding of risk; how to accept it and how to manage
it. Accepting risk means that you are
able to accept the outcome of your trades without emotional despair or
fear. It doesn't do any good to take on
the risk of entering a trade if you fear the consequences; doing so means that
you have not taken on the full understanding of risk.

The more successful traders not only take on the risk
without any trepidation or fear, but experience has taught them to actually
embrace that risk.

“When you genuinely accept the risks, you will be at peace with
any outcome”. Mark Douglas

Having a complete understanding and the willingness to accept risk does not happen overnight; it evolves over time as you fine-tune your trading skills. It all starts as you develop your trading plan and identifying those strategies and associated risk level that work in conjunction with your account size, and trading style. The full understanding and acceptance of risk does not come immediately to a new trader; it is developed over time with experience back testing, paper trading, and trading live starting with small positions. As you learn to identify the risk associated with each and every trade, you will be more prepared to accept the inherent risk that goes along with trading, and eventually embrace that risk.

Now, let's talk about Risk/Reward
Ratio and what it means in trading …

Risk/ratio is widely used by traders and financial
professionals all over the world when analyzing a trade or investment. Basically, risk/reward measures the amount of
reward expected for every dollar at risk.
The risk/reward with complex options strategies can be useful to analyze
positions to determine the relationship between the risk and reward.

Here is a very simple example of how
risk/reward is calculated …

Let's say a friend asked you to lend him $25. In return for your agreeing to the loan, your
friend agrees to pay you back $50 in two months. The reward (payback amount of $50), divided
by your risk (amount of the loan of $25) equals the risk/reward ratio. In this scenario, you would have a 2:1
risk/reward ratio. You are risking $25
for a potential reward of $50.

Why is it important for options
traders to calculate the risk/reward ratio?

Calculating the risk/reward ratio before entering a new
position is an exercise most professional options traders perform on a regular
basis. This habit can help you make a
better decision in your trading.
Sometimes, it may be surprising to see that the risk/reward ratio of
some strategies that you feel are a “win/win” strategy are actually
quite unfavorable when the math is worked out.
Calculating the risk/reward ratio before entering a position can help
avoid potentially unprofitable trades that are not immediately obvious. Many traders can also make it their own
personal policy to only trade positions where a certain risk/reward is
met. Some traders have as high a
risk/reward ratio of 4:1 as their “threshold”, although a ratio of
2:1 is commonly used by retail traders as this ratio “theoretically”
gives the trader the potential to double their money.

Let's look at some examples of a few options trades and the
risk/reward ratio associated with each of them.

Bullish
Call Spread on XYZ Company

XYZ is currently trading at $12, and you have a bullish
bias. You purchase a call debit spread,
+10 strike/-$15 strike at a cost of $1.50.
The maximum profit of the spread is $3.50 ($5, which is the width of the
spread, minus the cost of $1.50). If XYZ
closes at $15 above expiration, the full profit can be realized of $350 (less
commissions).

You enter a 10-point wide Iron Condor on ABC Company and
receive a credit of $1.25. The maximum
potential profit of the trade is $1.25 (credit received), as long as ABC
Company remains within the two short strikes.
Your total risk is $875 ($1,000 for the 10-point wide wings, less your
credit of $1.25).

In this second example, this type of risk/reward ratio is
considered by many traders to be unacceptable; where you are risking $875 to
potentially only make $1.25.

Summing it up …

Many options trades look and sound good at first
glance. Sometimes, inexperienced traders
may fall into the trap of not achieving their anticipated returns after
entering a position even though the underlying is performing as they
expected. The reason for this may be
that they did not understand the true risk/reward at trade entry. Traders who have a full understanding of
their risk, and the risk/reward of every trade before entering it can make a
more informed, intelligent decision on which strategy to implement in order to
maximize their profit potential.

If you are looking for a trading group where traders of all
experience levels share their trades and give excellent feedback, look no more.

I hope this article serves as a refresher on risk and
risk/reward. If you have would like to
add anything you have personally found helpful in your trading regarding risk, feel free to
comment below.

]]>https://aeromir.com/00576/risk-and-risk-reward-ratio-important-considerations/feed2Diversification; Why it is Important for Tradershttps://aeromir.com/00225/diversification-why-it-is-important-for-traders
https://aeromir.com/00225/diversification-why-it-is-important-for-traders#respondFri, 12 Oct 2018 11:53:31 +0000https://aeromir.com/?p=225

Diversifying your portfolio can help reduce some of the risks in trading, as well as help to maximize your returns. Most professional investment advisors will agree that while diversification certainly does not provide any guarantee to prevent losses, it can be a very important element in reaching longer-range income goals while minimizing risk. Most are familiar with the phrase “don’t put all your eggs in one basket”. The same goes for your trading portfolio.

There are two different types of risks for traders …

Undiversifiable risk. This is also referred to as “market risk”, and is relevant to all markets. Such occurrences as political instability, interest rates, exchange rates, inflation rates, and unknown events (war) … are all undiversifiable risk. This type of risk is not associated with any particular sector or industry, and cannot be eliminated through diversification. Undiversifiable risk is a risk every trader must accept.

Diversifiable risk. This is also referred to as “unsystematic risk”, and can be specific to a particular industry, market, economy, or country. This type of risk can be reduced through diversification, which is the focus of today's article.

When you diversify your portfolio … by trading different time frames, multiple markets, various strategies, and a variety of underlyings, you can generate more potential sources for profits. Diversifying by industry is also helpful, such as previous metals (gold, silver), airlines, pharmacies, construction, real estate, overseas markets, etc. All of this this helps protect you when the market shifts and puts any one particular strategy or underlying at a disadvantage.

What are some methods for diversification?

For those who are option traders, there are some diversification strategies they may want to consider. Multiple asset classes such as volatility instruments, bonds, stocks, ETF’s which follow the market, and ETF’s which follow the commodities markets can play an important role in protecting one's portfolio. When and if one market moves in a particular direction, the other asset invested in a different asset class may not be affected in a negative manner. Generally, the bond and equity markets move in opposite directions.

Using different types of strategies can be a good method to diversify. For instance, you may want to have directional long and short positions in play on different underlyings at the same time. These can be created as debit spreads, credit spreads, long or short calls and puts. Another good idea is to have some market neutral strategies such as iron condors and or butterflies.

Using different entry and exit times can help diversify …

When a trader buys or sells stock, there is not an expiration date. As long as the company stays in business there is value in the stock.

On the other hand, options have an expiration date which can allow a layer of diversity. This can be accomplished by having multiple positions in play, with short and long term expiration dates. If the positions are entered with different entry and exit expiration dates, it creates a layering effect. If the positions you are trading do not expire at the same time, it may help to reduce risk when there is volatility in the market. Another good quality of layering is all the positions do not expire at the same time which can give you more flexibility.

If the market is moving quickly, the longer term positions may need less attention than the shorter term positions. This can give you the much needed time to react to those positions which need an adjustment or exit.

Cash is a position …

It also makes sense in any trading portfolio to maintain a portion in cash. I am a firm believer of the phrase “cash is a position”. There are times that balance between capital allocated to the market, and cash may shift. Such times are in an extremely volatile market condition where it simply too dangerous to trade any market or asset class. The amount of capital you choose to set aside as cash also depends on whether you are a conservative or aggressive trader, as well as your risk tolerance.

Here are some key points for you as a trader to consider when diversifying your trading business …

However you choose to diversify your portfolio, it is important to remain within your range of experience. It will not help your success as a trader to begin trading any market, asset class, or strategy that has not been thoroughly tested. Remember, diversification only makes sense when you feel it can add unique value to what you are already trading.

It is also important not to over-diversify. This can be related to the popular belief that “more is better”. This is not always the case in trading. If the overall market begins to move quickly and there are too many positions in play, it can lead to difficulty managing the trades. Fear and stress can cause a trader to make poor decisions. Fear can even cause a trader to freeze up and be unable to trade. Over-diversification can result in lower-expected results, and a possible failure to reach your annual income goals.

In summary …

For any business to be successful over time, they must always be innovative, and add sources of revenue to take advantage of changing markets and types of customers. The same principals need to be applied for a trading business to remain successful. Trends change, markets change, and the level of volatility and risk change. Therefore, it is important for a trader to keep abreast of these changes and develop a trade plan which adapts to the market changes.

Think about diversification this way: it is like living a balanced life, where you get the proper mix of things such as exercise, nutrition, work, play, laughter, travel, quiet time, giving, friends and family time. When you diversify your life and have the proper mix of all of these elements, you're more apt to have a happier life.

Of course, creating a balanced life does not provide any guarantees that it will lead to a longer life; but it can help. The same goes with diversification in trading – there are no guarantees that by diversifying your portfolio you will not incur any losses, but diversifying can, at the very least, spread that risk over a variety of sources. When you diversify your trading business, you are more likely to experience better results over time.

However you choose to diversify your trading business, do your due diligence so that you are comfortable your trade plan has enough potential income sources to weather storms that you may encounter along the way. There is no specific model or guideline for diversification that will meet the needs of every trader. Choose your method so it aligns with your own tolerance to risk, and overall income goals. If, when researching methods to diversify your portfolio appear overwhelming with too many choices, consider consulting with a fellow trader or financial advisor who may help you in your decision-making.

If you have a specific mix of diversification that has helped you balance your portfolio and would like to share, feel free to comment below.

Are you looking for a trading group to share trade ideas and perhaps methods of diversification? Look no more! Aeromir offers a variety of trading groups, mentoring and educational trade alert services for all levels of experience. Join today!

]]>https://aeromir.com/00225/diversification-why-it-is-important-for-traders/feed0Weekly Options – Be Aware Of The Riskshttps://aeromir.com/00176/weekly-options-be-aware-of-the-risks
https://aeromir.com/00176/weekly-options-be-aware-of-the-risks#respondSun, 05 Aug 2018 18:59:02 +0000https://aeromir.com/?p=176Options trading becomes more and more popular every year. The options become more liquid and more traders use them for hedging, speculation, income etc. Weekly options (weeklys), introduced by CBOE in October 2005, are one-week options as opposed to traditional options that have a lifespan of months or years before expiration.

There are hundreds of options trading “gurus” promising you all kinds of ridiculous returns like “5% per week” or “10% per month”. What most traders don't realize are the risks that come with those returns.

What are Weekly Options?

As a reminder, options expire on the third Friday of every month. Weekly options, first introduced by CBOE in October 2005, are one-week options as opposed to traditional options that have a life of months or years before expiration. New series for Weekly options are listed each Thursday and expire the following Friday. In fact, many stocks now have weekly options going as far as 5 weeks.

Not every stock or index has weekly options. For those that do, it means that every Friday is an expiration Friday. That opens tremendous new opportunities but also introduces new risks which can be much higher than “traditional” monthly options.

Make 10% Per Week with Weeklys?

Question from a reader: What about selling the weeklies? The timeframe is very short and if you are more conservative, you can skip the weekends and start the trade on Monday and bet on about 4 days. You can still get about 10% return per week with very little risk.
To earn 10%, you must allow the options to expire worthless. That involves much more risk because each day comes with the tiny possibility of market-moving news.
If you can earn 10% per week and compound those earnings, after one year, $1,000 would become $142,000. I’m sure you cannot expect to win every week, but I hope that you recognize that it is impossible to earn such reruns with low risk.

I believe that your plan is fine for the experienced, disciplined trader who is skilled at managing risk. However, it is far too dangerous for the novice trader.

Be Aware of the Negative Gamma

Many options “gurus” ride the wave of the weekly options and describe selling of weekly options as a cash machine. They say that “It brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +.” They advise selling weekly credit spreads and present it as a “a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account”. What is the biggest issue with selling weekly options? The answer is the negative gamma.

The gamma is a measure of the rate of change of the delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price. For options buyers, the gamma is your friend. For options sellers, the gamma is your enemy.

Selling weekly options will give you larger theta per day. But there is a catch. Less time to expiration equals larger negative gamma. That means that a sharp move of the underlying will cause much larger loss. So if the underlying doesn't move, then theta will kick off and you will just earn money with every passing day. But if it does move, the loss will become very large very quickly. Another disadvantage of close expiration is that in order to get decent credit, you will have to choose strikes much closer to the underlying.

Common Mistakes

Here are some mistakes that novice traders do when trading Iron Condors and/or credit spreads:
• Opening the trades too close to expiration. There is nothing wrong with trading weekly Iron Condors – as long as you understand the risks and handle those trades as speculative trades with very small allocation.
• Holding the trades till expiration. The gamma risk is just too high.
• Allocating too much capital to weekly options.
• Trying to leg in to the trade and time the market. It might work for some time, but if the market goes against you, the loss can be significant and there is no another side of the condor to offset the loss.

Does it mean you should not trade weekly options? Not at all. They can still bring nice gains and diversification to your options portfolio. But you should treat them as speculative trades, and allocate the funds accordingly. Many options “gurus” describe those weekly trades as “conservative” strategy. Nothing can be further from the truth.